Economic Insights - October 1 - 5, 2018

Party like it’s 1969: Yes, headline job growth weakened, but in general, it was another fantastic report. Labor markets are key to our strong economic forecast and may even drive upward surprises.

Weekly highlights: Jerome Powell is loving the US economy right now. A new trade agreement between the United States, Mexico, and Canada is welcome news but doesn’t mean that trade tensions between the United States and China diminish. Italian budget woes linger.

Investment implications: The jobs report is just another sign that the US economy is terrific. With the latest move up in rates, the US bond market is finally buying into the robust growth story.

Party like it’s 1969

Below the disappointing headline, the September jobs report was quite strong. Topline payroll growth declined to 134,000; Hurricane Florence likely explained the weakness. About 300,000 people were out of work because of bad weather, compared to 85,0000 out of work because of bad weather in an average month. Upward revisions added 87,000 jobs over the last two months translating into a stout 190,000 three-month moving average pace.

The labor market is getting to be one of the tightest on record. The unemployment rate dropped two-tenths of a percentage point to 3.7%, the lowest level since 1969. According to J.P. Morgan, the unemployment rate for those workers out of a job for less than six months is the lowest since the 1950s! The broadest measure of unemployment, U6, while declining, has yet to breach the low reached in 2000.

Manufacturing added 18,000 jobs, a positive after weak job gains last month. In fact, goods-sector job growth has been accelerating as the pace of service job growth has flatlined. The continued strength in manufacturing suggests that trade tensions have had a negligible effect on hiring thus far. Temporary help added jobs for a third month in a row, a good sign for future job growth.

The drop in the unemployment rate came as the labor force participation rate held constant at 62.7%. Over the last few years, a lot of analysts expected the labor force participation rate to decline given the USs aging population. But a continual flow of workers from the sidelines back into the labor force has kept the participation rate steady. Throughout the period, the participation rate for prime-age workers accelerated. Strong flows into the labor force have supported robust job growth despite the unemployment rate getting very low.

Year-over-year, average hourly earnings decelerated modestly. Wages ticked up sharply last September in part because of Hurricanes Harvey and Irma, making a tough comparable for this September. But on a three-month annualized basis, average hourly earnings are up 3.75%, the second highest pace of the cycle, only behind last September’s temporary surge. Average weekly wages were up 3.4%, matching the fastest pace since 2010. Lots of leading indicators suggest that wage growth will continue to modestly accelerate in the coming quarters.

The robust jobs market is part of the reason why we think there may be room for more upward surprises for the US economy. If wage growth moves up more than expected, there may be scope for consumer spending to accelerate. Consumer spending has been constrained by muted pay growth. If that trend ends, some pent-up demand from consumers could be unleashed. A sustained pick up in productivity would likely keep inflation pressures controlled even as wage growth rises. That would mean that real household incomes would pick up, another welcome surprise. Faster wage growth could even bring more potential workers off the sidelines, supporting the already robust pace of job growth even longer.

Weekly highlights

Powell loving the US economy:

In speeches this week, Federal (Fed) Reserve Chair Jerome Powell stressed his delight in the US economy. He stated, “there’s really no reason to think this cycle can’t continue for quite some time, effectively indefinitely.” Powell emphasized that the policy was still accommodative, and that the US economy is far away from the neutral rate. He also stated the Fed may “go past neutral.” We expect that the Fed will likely pause when the fed funds rate gets close to 2.5% to 3%, that’s in the range where some Federal Open Market Committee members think neutral is.

NAFTA 2.0:

The United States, Mexico, and Canada agreed upon a new free trade agreement, now aptly called the US-Mexico-Canada Agreement. While the US Congress may not pass this deal until 2019, this deal reduces the tail risk of a trade war between the United States and its allies. This agreement also lessens the risk that auto tariffs will be put in place. Canada and Mexico are mostly exempt from auto tariffs. Auto tariffs on Japan and the European Union are also on hold with trade discussions underway. However, the new NAFTA deal does not make it any more likely that Trump will remove pressure on China. In fact, the United States may want to join forces with its allies against China.

Italian budget woes:

Last week, Italy announced 2.4% budget deficits for 2019, 2020, and 2021. Markets worried that the European Central Bank and Italy would disagree with these elevated levels. This week, the Italian government lowered the deficit targets for 2020 and 2021. However, GDP growth expectations used with those projections were well ahead of market expectations. A potential standoff between the EU and Italy remains a key risk in the Eurozone this year.

Investment implications

The strength of the US labor market is consistent with our view that nominal GDP growth will be around 5.0 to 5.5% over the next few quarters. With such a strong pace of economic growth in the forecast, it’s no surprise that the 10-year yield hit the highest level since 2011. We expect strong economic growth to keep yields elevated. With inflation expected to be muted, real growth will be the upward force on rates.

Markets have already reacted negatively to the updraft in rates. The trend that got started this week could continue. There is more room for good economic news, like another strong jobs report, to lead to a down-market day for both stocks and bonds. We talked about rates moving up to the 3.25% to 3.5% range, that process has started.

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